I just finished “The Little Book of Behavioral Investing” by James Montier. It is an amazing book with lots of great information. Highly recommended! One concept he touched on in the book is termed “Myopic Loss Aversion” which immediately caught my attention, so I want to delve into it a little in this post.
When it comes to investing, perfectly rational people sometimes make very irrational investment decisions, caused by numerous biases, but the most common of all is what is called Myopic Loss Aversion.
So what is it?
Loss Aversion (the fear of losing something) isn’t a bad trait to have. It’s sensible. What makes Loss Aversion irrational for investors is the Myopic part (the lack of foresight, being short-sighted). It makes us lose sight of the bigger picture.
It usually means panic selling during sharp market declines.
When a sharp market decline occurs, one is really supposed to jump INTO the market, buying as much as you can afford, since everything is “on sale”, but Mypoic Loss Aversion makes us do the exact opposite. Instead of taking a deep breath and “staying the course”, we jump onto the internet and try to sell our stocks as fast as possible.
Why is this?
Psychologists have shown that humans react to gains and losses in an a-symmetrical fassion. The amount of pleasure we get from a gain is usually in the order of about half the amount of pain we experience from a loss. For example, losing 10% in your stock portfolio usually feels about twice as bad as getting 10% growth in the same portfolio.
Behaviorists have noted a tendency for investors to check the performance of their portfolios too frequently. If an investor checks his holdings on a daily basis, he will experience many days of losses. Conversely, the longer the time frame between checks, the less likely it is that you’ll have a look right at the time when the portfolio have experienced losses.
Given that investors feel the pain of losses far greater than they feel the pleasure of gains, they are likely to not only experience disappointment if they check their portfolios with great frequency, but they are more likely to panic and sell as the pain of losses becomes intolerable.
So what do I need to do?
To make sure that I stay the course, I have to put down a few rules that I’ll need to follow. Through good times and bad times. Especially through bad times:
- Rule 1 – Don’t look at my investment portfolio too often. Leave it alone to do its magic.
- Rule 2 – Keep Rand-Cost-Averaging into my investments every month. Through good times and bad times. In fact, ESPECIALLY through the bad times, since then everything is on sale!
- Rule 3 – Never sell! Well, just about never. Once a year some rebalancing can be performed. This in fact is a good thing, since we’ll be selling some of the good performers (for example stock-ETFs in an up-market) to buy some more of the “under-performers” (for example our Bond-ETF). This forces us to work in a contrarian way, buying when others are selling and selling when others are buying. More about this concept in a later post.
- Rule 4 – Don’t panic!
Keeping the concept of Mypoic Loss Aversion in the back of our minds will help us stay the course when times get tough. I haven’t experienced a Bear market or a market crash in my investment “career” yet, but I assume it is nail-biting stuff!
Hopefully preparing ourselves better psychologically for when it comes (and it surely will!), we’ll be tough enough to not panic. And reap the rewards!